A broad review of recent market commentary shows that many local asset managers believe the rand is overvalued and have positioned their portfolios accordingly. However, not all fund managers consider this a foregone conclusion.
“We do not make currency forecasts and don’t build our portfolios on a directional rand view. As such, we do not believe investors should rule out the possibility that the rand could be stronger than anticipated for a sustained period,” says Lyle Sankar, fund manager of the PSG Money Market Fund.
“Current rand strength is partly attributed to ‘Ramaphoria’,” he says. “Many therefore argue that after the sharp re-pricing of South African assets since November, bonds and domestic equities are unattractive and rand hedges are the way to go.”
With this in mind, many investors are being advised to increase their allocations to offshore investments.
“While we consider global investments an essential building block for most domestic portfolios, we do not believe that offshore allocations should be based on currency predictions,” says Sankar.
“In addition, we are mindful that there is a scenario under which the rand may remain stronger than expected, for longer than expected.
“We are still of the view that South African government bonds and cheap domestic equities provide an opportunity for attractive long-term returns at relatively low levels of risk.”
Purchasing power parity
While the shortcomings of using purchasing power parity (PPP) as a predictive tool for currencies have been well documented, it still gives pause for thought.
(PPP is calculated on the inherent value of goods each currency buys in its home country. As a simple example, if a loaf of bread costs $1 in the United States and a similar loaf costs R8 in South Africa, then according to PPP, a dollar should cost R8.)
“Based on our PPP model, the rand is undervalued,” says Sankar.
“Market participants tend to extrapolate recent experiences, and we think many may be extrapolating the experience of the later years of the Zuma era, when the rand traded well below PPP fair value on a sustained basis.
“In total, it has traded weaker than the PPP value for four years, which is the longest period of successive weakness over the last 25 years.
“The sharp appreciation of the rand since November could thus be viewed as a partial reversal of fundamental undervaluation,” says Sankar.
“Contrary to popular perception, the rand has actually been strong relative to PPP value for 60% of the time since democracy, and this has generally been during periods of synchronised global economic growth, such as 2005 to 2007 and 2010 to 2012.
“We are currently seeing similar global economic conditions.”
Sankar also dispels the widely held belief that the South African economy needs a weak currency to grow.
“The period in which South Africa experienced the strongest sustained GDP growth over the past two decades was between 2004 and 2007 – and this period coincides with a strong rand,” Sankar says. “This was a period of synchronised global growth and low levels of South African inflation.”
Sankar says the South African Reserve Bank has been highly successful at anchoring inflation expectations within its targets over the past 15 years.
“It has managed to repeatedly suppress inflation to below the 6% upper limit, despite adverse conditions and extended rand weakness,” he says.
“CPI is currently at 4.5% and, given the SARB’s credible inflation targeting track record, we expect benign medium-term domestic inflationary pressure.
“Combined with a favourable global economic backdrop, this could lead to further interest rate cuts, which could provide a meaningful boost to our economy and potentially keep the rand stronger for longer,” Sankar says.
“While we do not deem a stronger rand a certainty, we therefore believe it prudent to account for the possibility. We would caution against building portfolios that will only do well if the rand weakens.”